The coming gold surge

Commentary: There are plenty of factors aligned to drive prices up

SeanBrodrick

JUPITER, Fla. (MarketWatch) -- Gold has enjoyed a great run over the past few years, but it hasn't been a straight path.

There have been enough dips and outright plunges to make gold traders feel like they're riding the devil's own roller coaster. But one strategy has worked time and time again: Buy the dips.

It takes courage to buy when everyone else is selling. But if you do your research, you can act with confidence that even if gold dips lower than you're buying it, the upside potential is huge.

My preliminary price objective for gold is $1,065 per ounce, and it could go a lot higher than that. Let's look at some forces driving precious metals higher.

Global gold production fell to a 10-year low of 2,444 metric tonnes in 2007, according to Gold Fields Mineral Service. This year, production will likely drop again. While China is producing more gold -- up 12% -- South Africa's output is falling off a cliff, down 8.1%.

Gold miners are exploring frantically, but the mother lodes are getting harder to find. This should drive consolidation in the industry going forward as the big companies gobble up the smaller fish to replace their reserves.

The most active gold ETF, the streetTracks Gold Shares
GLD, -0.69%
held 630 tons of gold at the end of January -- more than the European Central Bank or China's central bank. What's more, a new gold ETF in India is planned for this year.

Global demand for gold is exploding. Especially in places like China, where the first gold futures contract launched on January 9th. But also in the Middle East, where petrodollars are pouring into gold, and the gold trade in Dubai is accelerating.

The U.S. dollar is sliding

Since hitting a low in 2001, the Euro has nearly doubled against the dollar, but gold has more than tripled. The dollar and gold are on what I like to call "the see-saw of pain" -- as one goes up, the other generally goes down.

The Federal Reserve's actions are bullish for gold

In January, the Fed slashed its benchmark interest rate to 3%. It's the most aggressive rate-cutting since 1990, and I think Fed Chairman Ben Bernanke will keep cutting until rates are at 2.5%. Why? Because the Fed is worried that the U.S. is sliding into recession. Indicators include the worst January for retailers since 1996, plunging consumer confidence, and S&P 500 earnings expected to tumble for the second quarter in a row.

Looking ahead, one million adjustable mortgage resets will start hitting with a vengeance in April. The Fed will likely want rates as low as possible when that happens.

Lower interest rates weigh on the U.S. dollar, because international funds will flow to currencies with higher interest rates. So, cutting the benchmark interest rate is generally inflationary and bullish for gold. Adjusted for inflation, gold would have to hit $2,200 to hit its high from the early 1980s. Even if we get just halfway there this year, it could be one heck of a ride.

Ways to play the coming surge

If you think the U.S. is dragging its trading partners into a global recession, you'll probably want to own bullion, because the Fed and other central banks will pull out all the stops to reflate the economy, especially in an election year.

We're already seeing inflation. Last year, consumer prices rose 4.1%, the most since 1990. And despite some tough talk from Bernanke, I don't think the Fed gives a rat's patoot about inflation. It will risk that to avoid a deep recession.

A general inflationary trend should keep gold prices moving higher even if market malaise drags gold mining stocks lower. I think the easiest way to own gold is through one of the gold exchange-traded funds like the streetTRACKS Gold Trust. You don't have to store the bars or carry them back and forth to your local gold dealer.

On the other hand, if you think the Fed can stave off a recession and/or you think the global economy will chug along nicely even if the U.S. slides into recession, then gold miner shares could rally hard. The Market Vectors Gold Miners ETF
GDX, -1.59%
should fit the bill.

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